As we enter unchartered waters of monetary policy, analysts and investors are having to come to terms with concepts previously not considered. Negative interest rates, reversal rate and quantitative easing are three terms being widely discussed.
Negative interest rates
Negative interest rates occur when a bank charges the customer for storage of cash deposits rather than paying them interest. Japan, Sweden, Denmark, Switzerland and the European Central Bank all have negative interest rates.
While negative interest rates are rarely applied to consumer products, it is not unheard of for central banks to set a negative cash rate. One motivation for doing this is to encourage banks to lend money to consumers and businesses rather than leaving the money on deposit with the central bank where they will have to pay for holding positive cash balances.
The banks will theoretically encourage customers to borrow money by passing on the lower interest rates. This in turn also discourages customers from keeping money in savings accounts and term deposits.
The ultimate goal of negative interest rates is to stimulate spending and inflation. But, what happens when negative interest rates no longer have the desired effect?
Reversal interest rate
The Reversal Rate has also entered the investor lexicon. The Reversal Rate is the level at which interest rates start to have a negative impact on the economy. Monetary policy initially put in place to be ‘accommodative’ begins to have the reverse effect and starts to become ‘contractionary’ for lending.
Accommodative monetary policy is a form of economic policy used to stimulate and encourage economic growth by lowering short term interest rates. Money becomes less expensive for consumers and business to borrow.
Low interest rates decrease net interest income on new business which lowers banks’ net worth and tightens their capital constraints. At some point, banks cease lending amid concerns about their equity positions or their need to satisfy capital regulations.
Contractionary monetary policy is a form of economic policy used to fight inflation which involves decreasing the money supply in order to increase the cost of borrowing. In turn it decreases GDP and dampens inflation.
Determinants of the reversal interest rate
There are four factors which determine the reversal interest rate:
- Banks’ fixed income holdings
- The strictness of capital constraints
- The degree of pass-through of deposit rates
- The initial capitalisation of banks.
Over time the reversal interest rate creeps up since asset revaluation fades out as ﬁxed-income holdings mature while net interest income stays low. Regulatory reforms requiring larger deposit requirements and high-quality liquidity means banks are reluctant to engage in activity which generates sub-optimal returns on their investments. Quantitative easing increases the reversal interest rate and should only be employed after interest rate cuts are exhausted.
Since 2007, Europe, Japan and the US have been conducting an expansionary monetary policy known as quantitative easing or QE. Central banks increase money supply by adding liquidity to capital markets through large scale buying of assets, primarily bonds.
While there are mixed views as to the effectiveness of QE it is generally agreed that once enacted it is difficult to unwind.
Effects of QE and reversal interest rates:
- Banks may not pass on rate cuts
- Confidence in the economy lost
- Credit starts to contract
- Stagflation which occurs when there is inflation without economic growth
- Devaluation of domestic currency
- Increased borrowing by consumers and businesses
- Surplus funds can flow to financial assets rather than capital expenditure.
Consequences of low rates
Since the global financial crisis (GFC), central banks have enacted an unprecedented monetary policy of persistently low rates. This was done to cushion the economy from the resulting fall-out of the GFC and spur economic recovery while pushing inflation back up towards their objectives.
However, despite such efforts, the recovery has been lacklustre. In the core economies, for instance, output has not returned to its pre-recession path. If anything, growth has been disappointing. At the same time, in many countries, inflation has remained persistently below target.
Low rates and QE also create uncertainty among businesses and consumers, as a result business investment is weak across the globe.
How effective are unconventional monetary policies?
QE has been labelled the boldest policy experiment in the modern history of central banking. The jury is still out as to its effectiveness but there appears to be general agreement that while it was effective during an economic crisis it became less so as things returned to normal.
The US enacted QE as a result of the GFC in 2008 to address the bond and mortgage markets which had virtually seized up. This proved to be an effective measure, adding liquidity and getting the markets functioning again.
However, further bouts of QE combined with low interest rates has resulted in modest economic growth, but with increased asset values. Weak income growth means low and middle income earners have missed out on the wealth created while the wealthy have gotten wealthier.
QE and zero (or negative) interest rates have been in place overseas almost constantly since the GFC and in Japan for decades. While proven to have been initially effective in the US, Europe and Japan have not seen the same level of growth. Some analysts believe that the Eurozone could be on the verge of recession and in Japan the policy has been deemed a failure.
Back to the RBA …
The RBA is hoping that by enacting QE and lowering rates to zero or less, unemployment will be reduced. Low interest rates will also weaken the exchange rate. However, assets prices such as housing could rise even further.
Sceptics look to the lack of effectiveness in overseas economies and call for more fiscal policy measures. This may require the government to give up its goals of a budget surplus in favour of a stimulated economy.
Fiscal policy refers to the use of government spending and tax policies to influence economic conditions.